Interpret the real source of DeFi revenue and its common mechanisms

One of the most distinctive features of Decentralized Finance (DeFi) is the popularity of the concept of "yield". To lure users, new protocols are advertising ridiculously high numbers every day: 97% APR for these tokens, 69,420% APY for these tokens, etc. Of course, this feature of DeFi is also something that makes newcomers suspicious. How is it possible for a new protocol on a blockchain that you've never heard of to make 1 billion percent when the typical savings account has an interest rate of 0.5%?

This article will demystify the concept of DeFi yield, we will list the most common mechanisms by which DeFi protocols provide yield to their clients, in particular, we will make the following arguments:

DeFi revenue comes from the value of the underlying DeFi protocol, so locking your funds with a revenue-generating DeFi protocol is betting that the protocol itself has intrinsic value.

Definition of "yield"
For the purposes of this article, we define yield as the rate at which financial conditions are expected to generate value. This is roughly in line with TradFi's (traditional finance) definition of a bond's "yield to maturity" (YTM), the rate at which a bond reaches its face value at current prices. Broadly speaking, if you hold 1.0 units of value and deposit it into a protocol that yields 10%, you should expect to own 1.1 units of value after a year.

DeFi





face value
Notice how I use the word "value" above, how do I define "value"? The truth is, it's up to you: understanding the denomination of value is the key to understanding DeFi returns.

For example, let's say a DeFi protocol offers 1,000% yield for staking its native asset token. The token is currently trading at $2 per coin. You take $100, buy 50 tokens, stake the full amount, and expect to receive 50 * 1,000% = 500 tokens at the end of the year.

A year has passed and you have indeed received a return of 500 tokens: you have made a 1,000% gain! But right now, these tokens are only 1 cent each, which means your 500 tokens are worth $5 in total, and you're 95% off in USD terms. On the other hand, if the price per coin is $20, you now have $10,000 in chips, a yield of 10,000% in USD.

The point is: whether you think the 1,000% gain on these tokens is higher than the 95% loss on the dollar value is up to you, which depends on whether you think the intrinsic value of these tokens is higher than the dollar. (In this case, it probably won't.)

This example is used to illustrate that to understand the benefits of a protocol, you must understand the asset that pays the yield, and potential fluctuations in the value of the yield-paying asset are a risk to consider.

Calculate yield
Even with the correct denomination of value, the way yields are calculated can vary widely. Here are some common aspects you should be aware of when you see extremely high yields.

APR vs APY: The Annual Percentage Rate is the amount of added value you accrue each year. Annual yield is the amount of added value you accumulate each year, assuming compounding (i.e. dividend reinvestment). Depending on the specific agreement, it may or may not make sense to assume compound interest; use a number that better fits the agreement.


Lookback period: The APY data you see on a DeFi protocol can be based on data from some time period in the past: it could be the past day, the past week, the past year, or anything else. Given the variability in market volatility, protocol performance, etc., APY is expected to change dramatically. Therefore, the projected APY may or may not be the same as the actual APY, depending on past and future market conditions. Mitigate this risk by understanding the time frame of the calculation protocol APY data.
Explain APR: APR stands for Annual Percentage Rate, which is the actual annual rate of return, ignoring the effect of compound interest.

Explain APY: APY stands for Annual Percentage Yield, which is the actual annual rate of return, taking into account the impact of compound interest.

income mechanism

DEX/AMM

Decentralized exchanges (DEXs) and automated market makers (AMMs) are typical examples of yield-generating protocols. They are a seminal achievement in financial engineering dubbed "zero-to-one innovation in DeFi".

Here's how they work: Liquidity Providers (LPs) deposit pairs of tokens into liquidity pools. The purpose of these pools is to allow traders to exchange one token for another without an intermediary; the exchange rate is determined algorithmically based on formulas such as constant products. In return for depositing these tokens, LPs receive a portion of fees charged to traders proportional to the liquidity of the pool they provide, usually in the denomination of the pool tokens.

For example, in the past 24 hours, the TraderJoe USDC-AVAX pool received $156,000 in transaction fees paid to LPs. Given that the total value of the pool is $166 million, this corresponds to a liquidity provider's annual interest rate of $156,000 * 365 / $166 million = 34.2%.